United States: New IRS Partnership Audit Rules Are Around the Corner

Last Updated: November 4 2016
Article by James Usseglio

The Bipartisan Budget Act of 2015, enacted into law November 2, 2015, significantly changes the current Internal Revenue Service (IRS) audit rules that apply to partnerships and entities taxed as partnerships for U.S. federal income tax purposes by repealing and replacing the audit rules established under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) with a new set of partnership audit rules. Currently under TEFRA, the IRS makes audit adjustments to partnership returns at the partnership level, and assessment and collection of any resulting tax deficiencies from such partnership adjustments occurs at the individual partner level. Under the new partnership audit rules, IRS audit adjustments will also be determined at the partnership level, but any resulting tax deficiencies will now be assessed and collected at the partnership level, unless the partnership elects out of the new rules or elects to pass the audit adjustments out to its partners.

The new partnership audit rules are effective for tax years beginning after December 31, 2017. However, partnerships may elect to apply the new rules to returns filed for tax years beginning after November 2, 2015 and before January 1, 2018 upon receiving a notice of selection for examination. (The IRS has recently issued temporary and proposed regulations providing the time, form, and manner of making such election.)

Planning tip: While further guidance regarding the new partnership audit rules will be forthcoming from the IRS, interested parties should act now to consider the impact these impending changes will have on new and existing partnership agreements.

Executive Summary

  • The new partnership audit rules generally are effective for tax years beginning in 2018.
  • The new rules allow the IRS to make tax assessments and collections at the partnership level, rather than partner level.
  • Assessments generally will be made using the highest individual or corporate tax rate, regardless of partners' actual tax brackets or status as an individual or corporation.
  • Tax deficiencies resulting from audit adjustments will be assessed and collected from partnerships in the year the audit concludes, rather than the year under audit, thereby indirectly burdening current partners, rather than the partners from the audit year.
  • State tax returns generally must be amended if federal taxable income is changed as a result of an IRS exam. It remains to be seen how states will handle the new federal partnership audit rules.
  • Partnership agreements will need to address the new partnership audit provisions by 2018.

Default Rules – Partnership Pays Tax (and Penalties and Interest too)

Under the new rules, partnerships, rather than the partners, will pay any tax, penalties, and interest attributable to audit adjustments of a partnership's federal income tax return. The tax assessed will be calculated at the highest statutory corporate or individual income tax rate in effect for the year being audited. Currently the top individual tax rate of 39.6% exceeds the top corporate rate of 35%. Under these rules, 39.6% would apply. The amount of tax assessed against the partnership may be reduced if any partner of the partnership for the year under audit files an amended return reflecting his or her share of partnership adjustments and pays any tax due, or if the partnership can establish that a portion of the assessed tax is either allocable to a tax-exempt partner, or subject to a lower rate of tax (e.g. capital gain or qualified dividend income). The tax will be assessed against the partnership in the year the audit concludes (rather than the year under audit), thus potentially indirectly shifting the economic burden of the tax deficiency from any former partners of the partnership in the year under audit, to the current partners of the partnership in the year the audit is closed.

Certain "Small Partnerships" May Elect Out of New Rules

Partnerships that furnish 100 or fewer Schedules K-1 and that have as partners only individuals, corporations (including certain types of foreign entities), or estates may elect out of the new audit rules. Thus, absent further guidance, partnerships that have partnerships or trusts as partners cannot elect out. Special rules apply in cases where a partner is an S corporation. Additional guidance is expected from the IRS regarding this election including its application to partners treated as disregarded entities for federal income tax purposes. This election may be made annually with a timely filed return and by satisfying certain disclosure requirements. If a partnership elects out of the new audit rules, audits will be conducted and assessments will be made at the partner level.

"Push-Out" Election (But at a Cost)

As an alternative to the partnership paying the assessed tax deficiencies resulting from audit adjustments, a partnership may elect to furnish to each partner of the partnership for the year under audit and to the IRS a statement of the partner's share of audit adjustments. Each partner would then determine the additional tax, penalties and interest owed as if the adjustments had been properly reported in the year under audit, and report and pay such amounts owed with his or her return for the year in which the statement of adjustments is furnished from the partnership (rather than filing an amended return for the year under audit).

The partnership must make this election not later than 45 days after the date of the notice of final adjustment. The cost of making this election, however, is significant, as the underpayment rate of interest assessed to each partner on the amount of tax owed will be the applicable federal short-term rate plus five percentage points, instead of the normal three percentage points otherwise assessed under the default rules.

"Tax Matters Partner" Replaced With New "Partnership Representative"

The new audit rules replace the "tax matters partner" with a new "partnership representative." Unlike the tax matters partner under the TEFRA audit rules, a partnership representative need not be a partner of the partnership. Such person must have a substantial presence in the United States and shall have sole authority to act on behalf of the partnership under the new audit regime.

State Tax Implications

It remains to be seen how states will address the new federal partnership audit rules with respect to state income tax consequences of federal partnership audits, regardless of whether they conform to the new federal audit rules or not. For example, if a state conforms to the new federal audit rules, will the federal "push-out" or "small partnerships" elections be binding on the state, or will the state require its own elections? Alternatively, if a state does not conform to the new federal audit rules and a partnership pays the federal tax deficiency under the default rules, what reporting mechanism will exist for the partnership to provide its partners their share of the federal audit adjustments needed for them to pay the associated state income tax liabilities?

Conclusion

The new partnership audit rules apply to all partnerships effective for tax years beginning after December 31, 2017, unless partnerships elect to apply the rules sooner. The new audit rules will likely increase the number of partnership audits conducted by the IRS and make it easier for the IRS to collect any resulting tax deficiencies. As we wait for additional guidance from the IRS on specific issues such as, how some of the new audit rules will apply to tiered partnerships, interested parties should use this time now to consider the impact of the new rules on new and existing partnership agreements, as well as their potential impact on future mergers and acquisitions involving partnerships.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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